For those who have been out-of-touch with the financial markets over the past several days, here’s a news flash: they’ve been roiled by instability, volatility and (unless you’re a short) loss. Initially the culprit was so-called “sub-prime” mortgages – those made to borrowers of less-than-stellar credit stature. However, panic soon spread – as it is wont to do – among many other classes of asset-backed investments. “In recent months, confidence has ebbed in one market after another: first, subprime mortgages, then leveraged-buy-out loans, and more recently asset-backed commercial paper,” Ip, G. & Perry, J., “Credit Turmoil Tests Central Banks,” Wall St. J. (Aug. 10, 2007).
To appreciate the nature of the problem, you have to understand the nature of the investment. When a bank makes a loan, it typically doesn’t “carry its own paper,” like the car dealerships along Figueroa St. south of downtown Los Angeles used to advertise. Rather, it bundles all of those loans, and the accompanying collateral, into a portfolio, which it then sells or syndicates, to other financial institutions or institutional investors, such as pension funds. Those investors aren’t buying “your” mortgage, or anybody’s mortgage in particular, for that matter. Rather, they’re buying a risk-return characteristic. For example, there are people who pay their mortgages early; those who pay on time; those who are late; and those who are in default. Each one of these comprises a tier or “tranche” of the portfolio. And, the riskier ones carry a higher rate of interest. So if you’re a more risk-tolerant investor, you can earn a higher rate of interest, by buying a participation in the riskier tier.
The second thing to keep in mind is that (essentially) two factors affect the value of these portfolios. The first is, their own, internal performance. The second is prevailing market conditions. Let’s say you’re a “hedge fund,” and you’ve just bought $250 million of “risky” mortgage participations – buyers who either are in default, or who, on the basis of their track-record, likely will be in default soon. If more people than you anticipate go into default, what happens? Answer: the value of the portfolio goes down. This might happen, f’r instance, if the economy starts going south, and people lose their jobs. If you paid $250 million for the portfolio and its value begins to ebb, then it’s worth less than you paid for it; you’ve incurred a loss. You either (a) can’t re-sell it to somebody else for what you paid; or, (b) if you mark-to-market on your own books, as you may be required to do by GAAP or regulatory authorities, then it also shows as a loss.
But this isn’t the only hazard. The second is interest rates over-all. Let’s say when you bought that portfolio, it looked as though it would return 5% per year. Not bad, especially if (say) prevailing interest rates at the time were 3%. But what if the interest rates achievable from other, potentially less-risky investments, climb to 4%? Answer: the value of the portfolio goes down. Because anybody thinking about buying an asset-backed security can, on balance, achieve greater return with lesser risk. This is why everybody hangs with baited breath (whatever that means – sounds like a bad case of halitosis) on the actions of the Federal Reserve, which establishes U.S. interest rate policy. If the Fed “raises” the interest rate, it causes the value of every single asset-backed security to go down. If the Fed “lowers” the interest rate, they go up. Unless you adopt a complex hedging strategy, here’s nothing you really can do about this phenomenon, because you bought a specific investment, with a specific yield, at a specific moment in time.
The problem with too many actual or perceived delinquencies in the sub-prime mortgage market is that it has percolated over to other markets, as well. Next to go: securities comprising bundles of “ordinary” mortgages, where buyers make their payments on time. After all, they could go into default too, right? Then: securities comprising bundles of “extra good” mortgages, where buyers are so fastidious, they make their payments early. Same problem, n’est-ce pas?
And then we gracefully exit the mortgage market, and languidly float over to other types of asset-backed securities. This includes everything from equipment leases, to inventory receivables, to credit-card debt – anything, for that mater, that can be repackaged and securitized, using the template originally pioneered with mortgages.
This is where it gets pertinent. A year or two ago, more or less, studios began laying off an incredible amount of risk on off-balance-sheet financing vehicles. In search of higher yields in a tepid market, “hedge funds” pumped well over a billion dollars into these syndications. What were they buying? Not an individual movie, that’s for sure. Rather, a participation in a risk-return characteristic, backed by a studio’s slate of films. Instead of somebody’s house, the collateral for these investments comprised intangibles, such as the films’ future income stream, intellectual property rights, the film negative, etc.
If more movies in a portfolio tanked than anticipated, what happens? Answer (yes, if you’ve read this far, you know it already): the value of the portfolio goes down. This effect has been exacerbated by the fact that (a) most of the masters-of-the-universe running hedge funds don’t know jack sh*t about film investment (though the supply of nubile starlets, parties and limos seems to have remained constant); and (b) most of the time, the aforesaid masters-of-the-universe had no idea exactly what movies would be produced using their money (actually, the money they were managing on behalf of the aforementioned pension funds, representing the accumulated savings of widows, orphans, and other less-advantaged persons). While a few films may have been identified in advance, by-and-large these investments were presented as a “blind pool.” Not that it would have mattered anyway, I suppose, if they knew in advance exactly what it was they were getting into.
Oh yes, then there’s the minor problem that – with notable exceptions, of course – many movies this summer seem to have tanked.
I think the spate of film investment we saw last year – by hedge funds into film slates compiled by studios – illustrated an excess of hubris by hedge funds, and their managements. Their likely protestations notwithstanding, this investment was not adequately hedged. While in principle a portfolio of films looks like any other bundle of collateral, in fact it has unique risk-return characteristics that were insufficiently appreciated by hedge-fund managers. And even if everything goes exactly as it’s supposed to, it’s an “exotic” investment, therefore subject to greater volatility and unpredictability in an uncertain market.
This is why we won’t be seeing any more asset-backed film financing anytime soon.